Economy Outlook: KSE-100 Index Hangs by a Thread

Muhammad Faran

The stock market has continues to trade close to its low of 43K recorded on July 12th. This has been mainly due to an political pressures as the market had corrected by ~19% from its high (53.1K on May 25th to 43K on July 12th). This 19% correction, after all, is quite healthy given the historical average correction of 19% since CY2000.

It would not be fair to blame just the politics/ Panama leaks issue for this sharp correction. Other factors were in play as well: 1) Too many corporate events (mainly expansions) during the course of last year & a half set in the stage for an overbought market (a whopping 45.68% return in CY16) 2) MSCI story turned that event/ liquidity based rally into a hope based rally 3) Business as usual i.e. Budget FY17-18 came in with few negative surprises (flat CGT @ 15%, tax on dividends up by 2.5% @12.5%, no changes to tax treatment of bonus shares) 4) sell-off in E&P stocks post recent lows in Oil prices and finally 5) Net foreign selling post MSCI inclusion. However, investors still mainly remain overly-focused on the domestic political scene. Though, the fact of the matter is that there are other headwinds on the way as well that could restrict any major upside from here. Essentially, we all need to realize we are now in a situation that’s more often called a “Bear Market”. So this 9% upside from the recent low (43K on July 12th to 46.9K as of yesterday’s closing) could just be a “Bear Market rally”. Also, beware that equity market has now entered into the 3Q of the calendar year wherein the stocks usually stay sideways, choppy and directionless mainly due to the earnings season.

Interestingly, the equity market at least now seems to be gradually realizing the macro-economic challenges. We have just now started to hear some downgrades to the KSE-100 index forecasts for the year end as well. Things change! Also, expect more coverage on the economy in the coming weeks and months from the Analysts community in general. A classic case of Cognitive Dissonance!

Valuations, earnings growth, technicals (though a lagging indicator) & esp. the economic outlook are all suggesting caution. Any further rally above 48K-48.5K levels could provide a great opportunity to cut positions at strength in case you’re heavily invested. Safe bets (providing hedge against a sharply weakening PKR) would include Oil & Gas upstream, Banking, Power & Textiles if one is looking for building up a portfolio. Whereas, Steel stocks looks relatively attractive given its industry demand-supply dynamics.

SC’s disqualification verdict came in against expectations

Until last Friday (July 28th) when shockingly Mr Nawaz Sharif had to step down as PM after SC’s disqualification verdict, conventional thinking actually prevailed all along and in fact pretty much warranted the status-quo view. The series of political events have really unfolded at an unprecedented pace. All deadlines were given respect and throughout it seemed like Supreme Court (SC) didn’t have any time to lose. Great job! This certainly is a Paradigm shift, at least based on public perception & the media campaign, in our judicial system.

Well, this has pretty much remained the norm meaning that the last one year of sitting Govt. in Pakistan has mostly been quite noisy. Even with or without Panama leaks issue, one should’ve expected the domestic political noise to stay afloat throughout 2017 going into the election year in 2018. Just think for a moment, what else could the local chatterbox media cover to fill in their air time for the next whole twelve months?

Besides, for the first time in our history, both the major political parties have almost played their full innings. PPP has played the full 50 overs (2008-13) whereas PML-N almost 40 (2013 to date). Note that the last 10 are always very challenging. You really need to have the wickets in hand to complete your innings. So the next year’s federal elections (if PML-N survives in the Powerplay) would really be very fascinating to watch!

Government in conflict with the Central Bank over the exchange rate policy

The Government and the Central Bank also appeared to have been in a state of conflict lately. The recent drop in Rupee value by ~3% against the Greenback on July 5th provides a case in point when the SBP defended the move whereas the Finance Minister on the contrary, while getting frustrated with the acting SBP Chief, declared it “artificial”. Coincidently, this all happened on the same day when Maryam Nawaz had appeared before the JIT. And some still argue it was triggered by heightened level of political uncertainty. Anyhow, the Finance Minister was left with no option but to only fast-track the process of appointment of a permanent head of the Central Bank. And so we saw the Federal Govt. appointing Mr Tariq Bajwa as the new SBP Governor on July 7th i.e. just two days after the rupee’s sudden plunge. This simply speaks of the level of Government’s influence over the Central Bank’s policy.

Expect the Government to continue to dominate in terms of its views on exchange rate at least till their time lasts. The bitter truth is the Central Bank seems to be heading in the reverse direction in context of its role in policy making. The point is the less autonomous any Central Bank would be, the more problems an economy could through itself into. Again, that’s precisely the route that our country’s strategic leadership seems to have chosen.

Sham democracy & Pseudo economics should come to an end

Deficit financing, for instance, is the major driver of money supply growth in Pakistan and therefore remains a pivotal discretionary tool of how our economy is primarily run. It speaks volumes of the structural issues in our economy. Time will tell how the mix b/w private & public sector towards money supply growth would play out given so much jubilation around CPEC. The private sector’s limited contribution or willingness /and ability to contribute in Pakistan’s economy is also evident from the consistently falling Advance-to-deposit ratio of the banking industry. It’s not that there is shortage of funds to be loaned out; it’s just that there hasn’t been much appetite in case of advances to pick up. We haven’t seen any impact of CPEC here yet!

Besides, what was the point of revising the scope of tax on undistributed profits in the recent Budget? Could anyone from the Government explain this? Ideally, shouldn’t the Govt. be incentivizing the Corporates to reinvest their free cash flows into their businesses (instead of charging them extra taxes for lower payouts) esp. under CPEC when Corporates would hopefully find incredible investment opportunities as the Govt. itself has been portraying of late.

Ideally, every bit of news on CPEC should provide us with a moment of reflection. No doubt, this is a game changer for the people of this region. Though, opportunity favors only the prepared mind. And how well Pakistan is prepared for that kind of an opportunity could be a debatable topic. Mergers & acquisitions, private equity & cross-border listings would be picking up significant pace in coming years. Infrastructure, Energy, IT, Consumer goods & Services industry in general should remain in the limelight.

Now speaking of some key emerging risks on the economic front, particularly the external account, we could get caught between a rock and a hard place. On one hand, if the Rupee stays at current levels – that would continue to lead to sharply increasing current account deficit. Whereas on the other hand, if the Rupee gets depreciated, it would not only have a negative impact on our external debt servicing numbers but could also put upward pressure on interest rates. Widening twin deficits could seriously threaten macroeconomic situation. Current account deficit has already surged 149% Y/Y to USD 12.1 bn and consolidated fiscal deficit seems likely to cross 5.0% of GDP in FY17. Expansionary fiscal policy for FY18, targeting PSDP spending of PKR 2.1 tn, risks worsening twin deficits further.

There seems to be at least some momentum building up lately on foreign investment in Pakistan! That’s always encouraging. However, we have a long way to go. The point is that these FDIs won’t serve any useful purpose unless we address our structural issues by having 1) the right people for the right jobs 2) independent institutions with high accountability standards 3) strict adherence to transparency and above all 4) a clear vision that should drive policy setting. Unfortunately, we seem to be lacking in all these areas. No wonder why private sector couldn’t yet contribute to its fullest in Pakistan despite its huge potential. With few exceptions, if it’s not about expanding into existing family business, then real estate & public equities have remained the vital alternatives of late. And no wonder why individual investors are the top players in terms of daily value traded at the PSX. Their share is 60% in the total stock market activity and if you add the brokers’ proprietary books, that percentage goes to 73%!

Our economy has primary been run on debt and it has a set pattern that it follows. Under Army rule, it thrives and then during the manufactured democratic tenures, it fades until it gets so worse that Army comes back again for its rescue. And we are in no different situation right now. Though, this time shall too pass!

Looking at the proportion of external debt as compared to domestic debt along with the overall present debt level, the economy has enough room to borrow more debt which could possibly continue to help maintain Rupee at its present range. It would be interesting to see how long this could last. The total debt to GDP ratio offers quite a bit of room. Recall, when last time PML (N) was in power, the same ratio stood in the vicinity of 90%+ and here we are just sitting at around 76%! Doesn’t that offer a good appetite for destruction?! Basically, increased level of foreign borrowing has led to higher FX reserves and hence a Stable Rupee! It’s as simple as that. And along these lines, a question that comes to mind is if President Gen. Musharaf had also relied on building up external debt, how our sitting Government’s ex-Finance Minister would have been able to keep the Rupee stable at 105? Food for thought!

What’s really alarming this time is that we’ve a higher current account deficit despite relatively lower Oil prices under the current PML (N) govt. The sitting govt. has managed to accumulate USD 6.7 bn every year, on average, in the Financial Account, more than double the size of what was achieved under the previous two govts! An unprecedented level of external borrowings is what has helped build up Pakistan FX reserves in recent years. The sitting govt. has borrowed USD 5.1 bn every year, on average, as compared to USD 1.9 bn borrowed during PPP govt. (2009-2013) and a net retirement of foreign loans by the President Gen. Musharaf’s govt. (2000-2008)

The wrongly perceived macroeconomic stability achieved during the current government can be attributed to reforms initiated under the IMF program as well as windfall gains from global commodity rout. Nevertheless, decision to stimulate aggregate demand to boost GDP growth without proper build up in external buffers has raised external vulnerabilities, which threaten to reverse the economic cycle. Exports have remained at the tail end of economic priorities whereas non-essential imports have been encouraged through real currency appreciation, record low interest rates, and large scale public spending. Mobilization of fiscal revenues in the form of taxation of the untaxed and growth in exports remain critical to tackling growing economic problems.

And more importantly, the strategic leadership of this country needs not to repeat past mistakes. As earlier mentioned, the overall political economy can’t be rejuvenated unless the structural issues are addressed and resolved.

Muhammad Faran is IPI’s economy expert.